This is a great letter to the editor. I saw it in the print edition of Pensions & Investments, but I’ve given you the link. The author discusses the difference between time-weighted returns and money-weighted (more typically called dollar-weighted) returns. Here’s a big excerpt, some of which I put in bold for emphasis:
Many pension funds are still trying to recover from the devastation they’ve suffered as a result of the market downturn (“CalPERS goes with new risk-based allocation,” Pensions & Investments, Dec. 27). And many are seeing that using market indexes are the inappropriate metric to perform against, substituting absolute and/or liability-related benchmarks. But how many also see that the return they’re using is inappropriate?
Most pension funds, I would guess, only use time-weighting to measure performance. And why? Probably for a few reasons: because that’s the way they’ve always done it; because that’s what the GIPS, or Global Investment Performance Standards, require; because that’s the measure their consultants use and recommend.
They fail to recall that time-weighting was developed in the 1960s as a way to measure the performance of their managers, not their performance. The Bank Administration Institute, on the heels of Peter Dietz’s landmark thesis, put forward the first standard on performance measurement in 1968. This was followed in 1971 by the Investment Council Association of America’s standard. Both promulgated time-weighted measures, which eliminate, or reduce, the impact of cash flows. And why would they do this? Because managers don’t control the flows, their clients do.
So great, if you want to know how your managers are doing, use time-weighting. But when it comes to wanting to know how the fund itself is doing, why on earth are you going to eliminate the very cash flows which you control? To utilize time-weighting makes absolutely no sense. Money-weighting is the measure to be using. Yes, this means you’ll be calculating returns two ways, but that’s because you’re asking two different questions: How is our manager doing? And how are we doing?
Simply great-and this point is not emphasized enough. Managers do not control cash flows. Even when managers have good performance, clients typically do not. (This ridiculous story about world-class manager Ken Heebner and the CGM Focus Fund is the poster child for horribly timed cash flows. The corollary, I guess, is not to blame the manager for your own failings.) That’s why the DALBAR numbers are always so drastically lower than NAV returns. The NAV return shows the manager’s performance, but DALBAR calculates investor returns using dollar-weighting.
One way to dramatically improve your returns is to make like Steve Nash and give your portfolio an assist: add money to a sound strategy when the market has declined and you are feeling uncomfortable. Seth Klarman’s definition of a good client is one that is willing to consider adding money to an account after a period of underperformance. Good clients make even bad managers look good, and bad clients make even good managers look bad.
Source: theswamp51
Posted by Mike Moody 
